Quenching the thirst for commodities

Commodities are the foundation of our society — if we have no food or energy, we have no society.

The scenarios I highlight here will impact on commodity values. It’s not a matter of if; it’s a matter of when. Recently we have witnessed in the energy and base metal markets what happens to a commodity’s value when demand exceeds supply.

Population growth

The world’s population topped 6.4 billion in 2005, more than twice the number of people in 1950.

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While the actual population growth rate has declined from a high of over 2 per cent in the 1970s to slightly above 1 per cent in 2005, world population grew by an estimated 74 million people.

Each year, as they age, these 74 million people will want to drive cars, have electrical appliances, live in big homes, while consuming food and water, as we do now.

Fossil fuel use continues to grow

World oil use increased by 1.3 per cent in 2005, a significant slowdown from a record-breaking 3.4 per cent in 2004.

The US remained the world’s largest consumer, using 20.8 million barrels a day, followed by Europe (15.6 million barrels daily), China (6.6 million barrels) and Japan (5.4 million barrels).

On a per capita basis, the US uses two-thirds more oil than Japan and 13 times more than China. Fossil fuels are a finite commodity — we do not produce oil, we extract it, and the wells are emptying more quickly than at any time over the past 150 years.

Vehicle production continues to expand

There were 603 million passenger cars on the world’s roads in 2004, plus another 223 million commercial vehicles.

The US, Canada, Japan, and Western Europe had 552 million vehicles on a combined population of about 850 million. China and India, with 2.3 billion people, had just 39.2 million vehicles, or 5 per cent of the global total. But demand in those nations is growing rapidly. Personal transport is a luxury that everyone desires, yet it is a huge consumer of oil.

Food versus fuel

In a world of rising oil costs, almost everything we grow to eat can be converted to fuel (biofuel).

There are now two groups of buyers in world agricultural commodity markets — food processors and biofuel producers.

According to a recent Goldman Sachs report, Biofuels and food processors — Food Security vs fuel security, the “expansion of biofuels from today’s usage of a little under 2 per cent (of fuel transport needs) globally to 20 per cent, if applied just to the EU, would use up 61 per cent of the EU’s current arable land resource”.

“In the US, it has been suggested that just 10 per cent biofuel replacement would use up 43 per cent of arable land. While an immediate expansion of biofuels to a 20 per cent mix seems unlikely, a move towards these levels could lead to a rise in crop prices in the near term and increasingly raise the question of fuel security over food security.”

We will soon see grain prices lift because of the development of biofuels competing with increasingly higher oil prices.

The industrialisation of farming

In the 1950s and 1960s agriculture underwent a drastic transformation as it was industrialised. Between 1950 and 1984, as this industrialisation transformed agriculture, world grain production increased by an estimated 250 per cent. This additional increase did not come from introducing agriculture to new land (even though Brazil is cutting down the Amazon rainforest at an alarming rate).

The increase was provided largely through the use of fossil fuels, in the form of fertilisers (natural gas), pesticides (oil), and gasoline to drive machines to harvest motorised pumps for irrigation. So another reason for food prices to increase is the amount of oil used to produce it.

Farmland is deteriorating

Virtually all arable land on the planet today is being utilised by agriculture. What remains unused is too steep, too wet, too dry or lacking in soil nutrients. A substantial area of the world’s farmland is degraded, and this is increasing. Worldwide, land degradation has reduced cumulative food production by an estimated 13 per cent on cropland and 4 per cent for pasture over the last half-century.

Modern intensive agriculture cannot be sustained. It has created soil erosion, polluted and overdrawn groundwater and surface water, and (largely due to increased pesticide use) caused serious public health and environmental problems. Soil erosion, overtaxed cropland and water resource overdraft in turn leads to even greater use of fossil fuels. More fertilisers and pesticides must be applied, irrigation water requires more energy to pump, and fossil fuels are used to process polluted water.

Unless lower consumption rates are achieved, modern agriculture will eventually send major producing nations headlong into a water crisis. Along with increasing temperatures, this will impact on agricultural commodity prices.

Commodity supply will diminish and prices rise.

The good news is these are the makings of a great investment, and why it’s prudent to include commodities within a well-designed portfolio.

Greg Smith is the CIO of Global Commodities, an Australian-based hedge fund based on a quantitative investment model developed and applied in the commodity futures market for over 15 years. Greg has over 25 years’ experience in the commodities markets. This paper is abridged from a paper first presented at the PortfolioConstruction Conference 2006 www.portfolioconstruction.com.au.